The Italian Tragedy

Facing strong international pressure and a spiraling crisis, Italy’s new leadership may finally be forced to make long-avoided reforms.

Brought to office after the resignation of Silvio Berlusconi, Mario Monti has been the Italian prime minister for about four months now. It is too soon to judge Monti’s record, but it is distressing that the prime minister has not yet announced any substantial plan to deal with the very issue that makes Italy a great concern for Europe and the world: its huge public debt, which is over €1.9 trillion.

However, Monti’s sober, technocratic persona and his unexpected adroitness in the parliamentary arena have reassured the international community over Italy’s seriousness in facing its long-term economic problems.

An economist by background and a former European commissioner, Monti is as serious and reliable as Berlusconi was—to use a euphemism—flamboyant. With his first budget package, Monti accomplished a fiscal correction worth some €30 billion (two-thirds of it coming from new tax revenues) and an impressive pension reform that will substantially raise the retirement age. Later on, he announced a wave of “liberalizations” aimed at opening to competition a few of Italy’s most entrenched professions and market segments, but parliament made substantial amendments to the proposals.

Berlusconi never seriously tried to address the country’s fundamental problems. But the same can be said of the entire Italian political class.

To be fair to Monti, public debt has been part of the Italian political debate for decades, but very little has been done to address the issue. International observers frequently blame former Prime Minister Berlusconi. Certainly, besides his personal shortcomings, including several sex scandals, Berlusconi never seriously tried to address the country’s fundamental problems. But the same can be said of the entire Italian political class.

Italy’s debt-to-GDP ratio was 121 percent in 1994. In the late 1990s, ambition to join the eurozone led to fiscal consolidation that reduced that ratio to a more reasonable 108 percent in 2001. But no matter how you look at it, the debt has been growing in absolute terms and, despite some fiscal tightening and privatization in the late 1990s, Italy never really addressed its larger debt problems.

Instead of cutting public services, Italy largely and temporarily cut its debt by increasing taxes. The international press has focused on widespread tax evasion in Italy, but that should be put in context: Italians’ tendency to avoid taxes is rooted in a widespread sentiment that the system is irreformable, and therefore the only possible way forward is to circumvent it. Lack of pro-growth reforms and a despicable stubbornness in avoiding cuts to public spending and the restructuring of the welfare state have long convinced Italians to have low expectations of their political class.

Italy’s taxes are among the highest in Europe, with revenues estimated at 45 percent of GDP for next year, after the new fiscal correction. Paying taxes takes an Italian firm 285 hours per year, versus the OECD average of 186, according to the World Bank’s Doing Business project.

Italians’ tendency to avoid taxes is rooted in a widespread sentiment that the system is irreformable, and therefore the only possible way forward is to circumvent it.

Public expenditures have not been reduced substantially, despite the Maastricht Treaty and debt requirements to enter the eurozone. Public spending was 48 percent of GDP in 2001 and is now 50.5 percent of GDP. No major reform of the universal and “free” healthcare service has been undertaken (in spite of successful experimentations in the region of Lombardy with a system allowing limited competition by private providers). Major attempts were made to reform the pension system, but it is still far from stabilizing. Welfare remains a major waste of public finances.

Despite all this, Italy is not the most spendthrift of OECD countries: the French, Swedes, Danes, Hungarians, and Austrians are worse. But unlike some of those countries, Italy did not institute pro-growth reforms. Low productivity growth in Italy has been the rule ever since the 1990s, and labor productivity has been declining since 2007. While Italy still nurtures successful entrepreneurs and several thriving, export-oriented business sectors, even the vibrantly entrepreneurial Italian economy (still the third biggest in the eurozone) could not forever withstand the burdens of a heavy state and cumbersome rules. Particularly in the service market, Italy needed robust liberalization. This has occurred in the energy and mobile communications sectors, but most of the economy has escaped deregulation. Monti’s most recent measures looked like a very homeopathic dose of market-friendly reform (focusing mostly on rather marginal segments of the economy like taxi cabs and the distribution of pharmaceuticals) for an economy that ranks 92nd in the Heritage-Wall Street Journal Index of Economic Freedom. But even these minor reforms have encountered major obstacles in the Italian parliament.

Why is it so difficult to liberalize the Italian economy, in spite of such an obvious need to release it from red tape and regulations? The late Mancur Olson argued that once rent-seeking coalitions form and consolidate in a society, it becomes extremely difficult to escape a dysfunctional equilibrium. Berlusconi’s failures could be reduced to this very point. Entrenched interests have prevented necessary institutional change and provoked political decay. The political class decided to pander to people living off public spending, as they are a major interest group and perceived as a constituency that cannot be ignored. Public expenditure was conceived as untouchable.

Mancur Olson argued that once rent-seeking coalitions form and consolidate in a society, it becomes extremely difficult to escape a dysfunctional equilibrium.

Now Italy is under a de facto receivership by the European Union and has an unelected government that may have a window of opportunity to make necessary reforms. There is very strong international pressure, as the crisis is spiraling. Still, so far pro-growth policies have not been pursued because they would have required strong action against powerful interest groups. Instead of taking an axe against public spending, so far Monti has preferred a less politically dangerous approach of raising taxes across the board.

Monti is a composed economics professor, not a revolutionary warrior. He is also a prime minister who needs to deal with a vast coalition, including both the largest left- and right-wing parties, and therefore needs to raise the widest consensus possible to move forward. But when it comes to removing barriers to entry, cutting public spending, and liberalizing the rigid Italian labor market, a wide consensus may be difficult to reach.